Following the cohort.

Category Archives: Cat modeling

Sarasota Herald-Tribune reporter Paige St. John is questioning the clothing choices of cat modeling emperor RMS in a well-sourced series that makes a lot of good points if you can get past all of the insurance bashing. However, the case she proves is not the one I think she wants to make.

She accuses the leading cat modeling firm, RMS, of basically gaming its own black box, the computer model that projects losses from major storms, most famously hurricanes. Insurers use models like those of RMS to project how much it should cost to insure their portfolio of risks. Since RMS is the No. 1 cat modeling firm, any bias in its models will skew homeowners’ rates in cat-prone states like Florida.

She also notes that the models suffer from GIGO syndrome. The data fed into them can be notoriously inaccurate, so the estimates they spit out could be unreliable. Most famously, the Mississippi casinos washed away by Hurricane Katrina were basically floating barges, but were geocoded as traditional anchored building. When Katrina struck, they tossed about like mobile homes, creating losses far greater than any model could have anticipated.

She also accuses the insurers and reinsurers of playing along with the cat modeling game, as it conveniently led to higher rates.

An update on this item regarding Perils’ development of a 1-in-200 year cat loss as part of Solvency II’s QIS5 analysis:

I wasn’t sure how you get a diversification benefit from a single catastrophe. Turns out we’re not looking at one catastrophe here:

But it's still a lot of euros.

The graph shows the 1-in-200 loss for each country. The sum of all of the losses is €52.5B. However, it is extremely unlikely that each country would incur its 1-in-200 loss in the same year. Hence, the diversification benefit of €15.8B.

European insurers have to be able to manage a regional windstorm that could cause 36.7 billion euros ($51 billion) in insured losses under proposed new risk-based regulation, Perils AG said.

Perils is the official scoreboard for European catastrophes, founded in 2009. It collects loss information about European cats, the major one being winter windstorms. In the U.S., PCS provides a similar service.

Solvency II calls for capital to cover a 1-in-200 storm. Perils estimated one for nine areas: Belgium, Denmark, France, Germany, Ireland, Luxembourg, the Netherlands, Switzerland and the United Kingdom. The results are in the graph below:

That’s a lot of euros.

(I’m a little puzzled by the diversification effect in this chart. Usually diversification effects come from insuring different lines of business, so I’m not sure why a major storm would have a diversification effect. Could €36.7B be the capital charge stemming from an insured loss of €52.5B? Stories and the Perils press release aren’t clear. Feel free to clue me in via comments.)

By contrast, Hurricane Katrina is the worst U.S. disaster, with $41 billion in insured losses onshore, another $2 billion or so from offshore oil rigs and another $16 billion from flood insurance, which the federal government provides.

At a Reactions magazine insurance event, U.S. regulators showed their frustration at having to qualify as Euro-compliant. Quoth FL Commissioner Kevin McCarty:

Solvency II is a theoretical standard – it is not in place yet. It is difficult to say what effect Solvency II would have, because it is not yet implemented, whereas we have 130 years of experience.

The problem: With Solvency II, Europe regulators have leapfrogged U.S. regulators. They are setting cutting edge standards, and the size of the giant European insurers and the openness of the market mean America has to follow. And the Americans aren’t used to that.

This year, the European regulator CEIOPS picked out the countries whose regulatory regimes could be ruled equivalent to the European standard. The U.S. got left off – blame America’s state-based regulation. We have 50 regulators. Europe has one. So the U.S. was too complex and too expensive to evaluate.

Given the pedigree of U.S. insurance regulation, that’s difficult to accept. NY Superintendent James Wrynn:

If you took the U.S. system and placed it over Europe, it would work perfectly with the EU member states.

And U.S. regulators are leery of S-II’s reliance on the company’s own computer models, Wrynn said:

Doesn’t the over-reliance on internal models complicate the role for regulators? Do they understand it? And people will game it, the Enrons of the world.

Meanwhile, U.S. regulators are doing their own update of solvency standards, the Solvency Modernization Initiative. As I’ve reported before, that is likely to keep the current risk-based capital system, but add some modeling for out-of-the-box risks like catastrophe exposure. The initiative will play out over the next couple of years.

Tidbits I picked up at the Casualty Actuarial Society’s Casualty Loss Reserving Seminar:

The NAIC update of its solvency standards is unlikely to have the sophisticated modeling possibilities that Solvency II has in Europe. (Recall S-II creates a model to set capital, then basically suggests that insurers that could do a better job should submit a model.) NAIC seems much more inclined to tweak its current model, risk-based capital. Two key concerns: the cost of reviewing hundreds of models would be prohibitive and small insurers might be put at a disadvantage.
The main RBC tweak would a charge for cat exposure, using cat models. This has been kicking around for a couple of years. Reinsurers don’t like it, as they don’t want to be responsible for the quality of data provided them by cedents. These are early days, of course, and this could all change.

The New York Insurance Exchange seems to be on hold. I wrote about it here. Basically, NY Gov. Paterson is the force behind the idea, and he leaves office after the November elections. Next steps will await the new governor.

Discounting of U.S. reserves seems almost certain with the overhaul of U.S. accounting standards. Right now, the IASB contemplates a discount with a margin for risk and a residual margin (the contract’s expected profit). The risk and residual margins will run off as the insurance contract ages. FASB, the U.S. accounting board, is nodding in the same direction, though the risk and residual margins are combined into a single composite margin.
But either standard would use discounting. And statutory accounting principles may well follow suit. That would have a knock-on effect on RBC, since one of RBC’s capital charges is on reserves. And if reserves are discounted, the capital charge would be artificially low.
Of course, as one speaker pointed out, RBC and statutory accounting are a bit duplicative. Statutory accounting disallows certain non-liquid assets in calculating surplus – as a precaution. RBC models the capital needed given the companies risk profile – as a precaution.